We believe that a last minute deal will raise the federal debt limit and permit the payment for twelve to eighteen months of federal bond interest coupons, supplier invoices, employee wages, grants and entitlement benefits. However, this does solve the deficit spending problem; the deficit is still running at $1Trillion plus per year. A debt limit increase only postpones large, abrupt spending cuts forced by creditors as has happened recently in many European countries. Relaxing the artificial borrowing constraint we imposed on ourselves will permit the economic recovery to proceed for several years at a subpar pace and permit the long delayed construction recovery to begin soon at a subdued pace.
Too much focus is being put on the debt limit increase and too little on the deficit spending problem. Yes, there would be chaos in financial markets, perhaps worse than in September 2008, if the US defaults on bond interest payments. But the probability of this happening is near zero. Even if the debt limit is raised a few weeks late, annoyed bondholders would be patient because they would still expect to be paid in full. The concern set off by late payments would take a big bite out of 3rd quarter GDP but would not lead to a recession.
Deficit spending remains the core problem. This is already constraining economic growth. The phase out of the various stimulus plans and the effective freeze put on federal spending by congressional republicans has turned the federal fiscal impact negative. Reduced federal spending cut at least 0.5% from 1st Q GDP growth. This almost certainty continued through spring and into the summer.
Larger federal spending cuts would add to the constraint on economic growth for a while before they freed up capital and boosted confidence enough for added private spending to offset reduced government spending. But there is little likelihood of large immediate spending cuts. No one in Washington wants to face a crowd of constituents who did not get the federal check they were expecting. Even the proposals offered by the republicans have been progressively backing down on the amount of immediate spending cuts. The deficit reduction commission (Simpson-Bowles) had the most and each successive plan has had less. This includes the 10-year budget plan passed by the House of Representatives earlier this year, the Cut, Cap and Balance plan passed by the House last week and the scaled down spending cut-debt limit increase being offered by the House republicans this week. This plan includes only $1 Billion in spending cuts in FY 2013 in a ten year $850 Billion plan.
Your plans should expect subpar economic growth for several years averaging about 2.5% but likely below this later this year and correspondingly above the average in 2012. Then we will repeat the debt limit crisis in 2013 when the accumulated debt has risen to $17 Trillion.